Termination Fees Give
REIT Earnings a Boost

Despite the weak economy, most big real-estate investment trusts that own office properties managed to either meet, beat or come pretty close to earnings expectations in the fourth quarter of 2001.

That isn't necessarily good news.

To understand why, you need to look at what helped boost the REITs' bottom lines. When an office tenant breaks a lease, it usually has to pay the landlord what's called a termination fee. These fees have been climbing as contracting or closing companies scale back or unload their office space. Some office REITs have been adding more fees collected in these lease terminations to their earnings as profit.

Though not huge, the fees are hardly inconsequential. Equity Office Properties Trust, the nation's largest office landlord, would have missed analysts' estimates for fourth-quarter results had it not been for the $24.4 million it generated in lease-termination fees. The Chicago-based REIT's 82 cents a share in funds from operations -- a supplemental earnings measure used to gauge REITs' financial performance -- came in line with estimates compiled by Thomson Financial/First Call. The fees amounted to about three cents a share.

Duke Realty Corp., Indianapolis, missed analysts' estimates by two cents a share, but the gap would have been wider had it not been for its lease-termination fees. Duke reported funds from operations of 63 cents a share for the fourth quarter. If not for the $8.4 million in lease-termination fees it booked for the quarter, funds from operations would have been five cents lower, or 58 cents a share.

"We're seeing the numbers positively impacted," says Gregory J. Whyte, an analyst at Morgan Stanley in New York, "but it begs the question, how would earnings have been without them?"

Tom Peck, a spokesman for Duke, says the company expects to book nearly $2 million more in lease-termination fees this year than last, mostly in the first and second quarters. He says the company would agree to a lease termination if "we can negotiate a price where we are extremely comfortable that we can re-lease the space in a time frame and a cost that allows us to make more money than we would have made had we not accepted the buyout."

But the fees are a double-edged sword. While they help the landlord cover a portion of the rental income they lose while the space is vacant, they also mean the space is vacant.

Another downside: "They're a one-time, positive impact, not necessarily recurring," says Mr. Whyte. "And one gets an increase in vacancies" at a time when demand for office space has fallen.

In more flush times, termination fees were hardly a bad thing: REITs pocketed the fees, then re-leased the vacant space so quickly that they were, in effect, getting a double pop on income from the space. "Now they're getting term fees and not re-leasing the space as quickly," says John Lutzius, an analyst at Green Street Advisors Inc., Newport Beach, Calif., "so they're only getting partially compensated for the space."

For that very reason, some REITs have gotten stricter about tenants' ability to break leases, and not every office REIT recorded increases in term fees during the fourth quarter.

"Given the softness of the real-estate market, we have made it so that most tenants would find terminating their leases un-economic," says Phil Hawkins, chief operating officer of CarrAmerica Realty Corp., a Washington, D.C.-based office REIT that recorded $6.8 million in term fees in 2000, compared with $2.5 million in 2001.

"We're more conservative in assumptions to lease up that space now," he says, whereas in the past, the company often was able to get a replacement tenant quickly.

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